DISCOUNTED CASH FLOW
Answers to Concepts Review and Critical Thinking Questions
Assuming positive cash flows and interest rates, the future value increases and the present
Assuming positive cash flows and interest rates, the present value will fall and the future
value will rise.
The better deal is the one with equal installments.
Yes, they should. APRs generally don’t provide the relevant rate. The only advantage is that
they are easier to compute, but, with modern computing equipment, that advantage is not
A freshman does. The reason is that the freshman gets to use the money for much longer
before interest starts to accrue.
It’s a reflection of the time value of money. GMAC gets to use the $500 immediately. If
GMAC uses it wisely, it will be worth more than $10,000 in thirty years.
Oddly enough, it actually makes it more desirable since GMAC only has the right to pay the
full $10,000 before it is due. This is an example of a “call” feature. Such features are
discussed at length in a later chapter.
The key considerations would be: (1) Is the rate of return implicit in the offer attractive
relative to other, similar risk investments? and (2) How risky is the investment; i.e., how
certain are we that we will actually get the $10,000? Thus, our answer does depend on who
is making the promise to repay.
The Treasury security would have a somewhat higher price because the Treasury is the
strongest of all borrowers.
The price would be higher because, as time passes, the price of the security will tend to rise
toward $10,000. This rise is just a reflection of the time value of money. As time passes, the
time until receipt of the $10,000 grows shorter, and the present value rises. In 2010, the price
will probably be higher for the same reason. We cannot be sure, however, because interest
rates could be much higher, or GMAC’s financial position could deteriorate. Either event
would tend to depress the security’s price.